What is the National Debt?

It's a rare public opinion poll these days that doesn't show the national debt near the top of Americans' concerns. Huge budget deficits as far as the eye can see are a source of great worry, encouraging many people to join the so-called tea party movement to demand fiscal responsibility. President Obama has responded by asking for a freeze on nondefense discretionary spending, and appointing a commission to study the deficit and make recommendations for reducing it.

Before we can take meaningful steps to control the debt--or even understand its true cost and effect on the economy--we first have to understand what it is. At its most basic level, the national debt simply consists of all the federal deficits in history minus budget surpluses. For fiscal year 2009, which ended last Sept. 30, this amount came to $7.5 trillion.

Obviously this is an astronomical sum. But it really tells us almost nothing unless we look at it in context. Economists generally look at the debt in relation to the nation's total output of goods and services, which is the gross domestic product. The debt came to 53% of GDP last year, up from 40% the year before and 35% in 2000, but down from 109% at the end of World War II.

Another way of looking at the national debt is as a share of total credit market debt, which includes home mortgages, corporate debt, credit card debt and so on. In 2009 the national debt equaled 22% of total credit market debt. This was up from the 17% to 18% level that prevailed throughout the 2000s, but is actually down from the level that prevailed during most of the postwar era. In 1950 the national debt was more than half of all credit market debt, in 1960 it was about one-third and it was more than one-fourth in 1995.

Throughout most of the postwar era the national debt fell steadily as a share of GDP. This was partly because the economy grew faster than the debt, but also because inflation eroded the value of the debt. The $250 billion debt that existed at the end of the war would have been $2.3 trillion if calculated in today's dollars. By the mid-1970s, the real (inflation-adjusted) debt had fallen by 40% even though the nominal debt rose more than 60%.

Another important issue is the gross debt vs. the debt held by the public. This confusing distinction exists because for some years the federal government has taken in more in Social Security payroll taxes than needed to pay immediate benefits. By law this surplus is invested in special Treasury securities that are part of the debt subject to the debt limit that Congress must raise from time to time.

At the end of 2009 the gross debt was $11.9 trillion, $4.3 trillion more than the debt held by the public. Although many people get excited about this figure, it is in fact economically meaningless. The Treasury securities held in government accounts really amount to nothing more than budget authority permitting the Treasury to in effect use general revenues to pay Social Security benefits once current Social Security tax revenues are insufficient to pay current benefits, something that will happen in the year 2015, according to Social Security's actuaries.

Another confusion is that the Federal Reserve is treated as part of the "public" when debt held by the public is calculated. This is awkward because the Fed is part of the government and holds vast quantities of Treasury securities, with which it conducts monetary policy. (When the Fed buys them it increases the money supply; when it sells them it reduces the money supply.) At the end of fiscal year 2009, the Fed owned about $900 billion in Treasury securities. (The Treasury pays interest to the Fed on these holdings, but the Fed then gives almost all of it back to the Treasury.)

As big as these numbers are, they really only touch the surface of the federal government's indebtedness. The full scope of that appears annually in something called the Financial Report of the United States Government. The latest report was issued Feb. 26. According to it, in addition to the national debt, the federal government owes $5.3 trillion to veterans and federal employees. But the really big debts are those owed by Social Security and Medicare: Over the next 75 years, the federal government has promised benefits for these two programs in excess of anticipated payroll tax revenues equal to $7.7 trillion and $38 trillion, respectively.

The Treasury Department estimates Social Security's deficit at 1% of GDP over the next 75 years and Medicare's deficit at 4.8%. With federal revenues estimated to be about 19% of GDP in the long run under current law, taxes would have to rise by about one-third to pay all the promises that have been made for just these two programs.

The Office of Management and Budget estimates that in the absence of massive cuts in Social Security, Medicare and other programs, or an equally massive tax increase, the national debt will rise to 77% of GDP in 2020, 100% of GDP in 2030 and more than twice GDP by 2050.

Economists are divided on the point at which the federal debt becomes a meaningful burden on the economy. A recent paper by economists Carmen Reinhart and Kenneth Rogoff suggests that historically growth has not suffered significantly until debts reached 90% of a nation's GDP.

Some Pollyannas, like my friend Larry Kudlow, think we can just grow our way out of the debt by cutting taxes. But this is not really possible given the magnitude of our problem. First, increasing real growth doesn't have as much effect on the debt as one might imagine. According to OMB, raising the rate of productivity, the basic component of real GDP growth, by 0.5% per year over the next 75 years only reduces the long-run fiscal gap by 17%.

Moreover, raising productivity even that much would be hard; over the last five years the productivity growth rate has averaged 1.8% per year, so we would have to raise it by one-fourth just to reduce the projected debt by 17%. And we can't very well expect investment to raise productivity very much when the federal budget deficit will be absorbing a huge percentage of national saving, crowding private borrowers out of the market, which will reduce business investment. Lastly, it's highly unlikely that further tax cuts will do much to increase growth when they will add to the deficit and taxes are already at their lowest level as a share of GDP in almost 60 years--more than 3% of GDP below the postwar average. In any case, the biggest problem businesses have today is a lack of customers, not high taxes.

When people talk about growth reducing the burden of debt they are sometimes implying that inflation will solve the problem. If nominal GDP grows faster it doesn't matter whether it's due to faster real growth or higher inflation, many economists think. The problem with that belief is that it assumes that the debt is largely composed of long-term bonds with fixed interest rates.

Unfortunately the portion of the national debt held in the form of long-term securities has fallen over time, and the percentage in short-term securities has grown. As of Sept. 30, 2009, three-fourths of the privately held public debt matures in less than five years. This debt can't be inflated away because investors will demand higher interest rates to compensate for inflation when it rolls over, which will raise federal spending on interest payments. Also a growing portion of the debt is now indexed to inflation. Known as Treasury inflation-protected securities, more than $500 billion have been issued. Insofar as the additional spending for interest is borrowed, the real value of the debt won't fall very much.

Even in the absence of higher interest rates, growth in the debt will sharply raise the government's interest payments from 1.3% of GDP this year to 3.5% in 2020, 4.5% in 2030 and 10% in 2050. At that point half of all federal taxes will be going just to pay interest on the debt, which by law stands first in line before all other claims.

Another problem is that almost half of the debt held by the public is now owed to foreigners, up from 31% in 2000 and a historical level of less than 20%. Foreign investors will be concerned not just about inflation, but the exchange value of the dollar because all of our debt is denominated in dollars. If they fear that the dollar will drop against their currency they may demand an even higher interest rate as compensation, or insist that the Treasury issue bonds denominated in foreign currencies, which will shift all the foreign exchange risk to the taxpayer.

Recently some foolish bloggers have suggested that it would be better to default on the debt than raise taxes. That would, of course, cause tremendous hardship for millions of Americans because some $800 billion in Treasury securities are owned by private investors, almost $700 billion are owned by mutual funds, more than $500 billion are owned by state and local governments and more than $300 billion are owned by pension funds, among others. I tend to think that they won't take too kindly to the idea that raising taxes would be worse than paying them the money they are owed. In the end the debt must be paid, and we will have to raise taxes and cut spending to make sure it is.

Seems to me that a superior measure of our ability to finance/service the current and projected federal debt held by the public would be a metric that measures current and projected debt held by the public relative to (current & projected) GDP AND net worth (and its components, assets and liabilities). After all, one's credit-worthiness isn't measured simply by income, nor even by income and one's other credit outstanding, but also one's assets and net worth.

Granted, it would be a more complex and perhaps somewhat problematic metric in practice, since private net worth is volatile and more complex, and not only could measurement methodology be subjectively debated, but valuations of many assets themselves are the subjective.

I think I've seen (in the mass media, blogs, etc.) the debt expressed relative to national net worth, but it's rare, and I don't recall if I've seen it expressed as comprehensively as would seem ideal to me.

... a superior measure of our ability to finance/service the current and projected federal debt held by the public would be a metric that measures current and projected debt held by the public relative to (current & projected) GDP AND net worth (and its components, assets and liabilities)...

The rule of thumb is to measure stocks versus stocks and flows versus flows.

For the US the flow measure is the cost of debt service in taxes compared to government revenue, or national income or GDP.

The stock measure is the size of the national debt compared to ... this one's tricky. What are the assets of the US government? The Grand Canyon and national parks? All the wealth of the citizenry that the govt thinks it can seize one way or another?

But in practice it is the flow measure that counts. When politicians find the flow measure has gotten too politically painful, and reach the point where they consider the alernative of inflation and/or default less so, they act accordingly.

It is the flow measure that in Greece has rioters in the streets today, and cost Louis XVI his head.

Sure, cash flow (literal inability to service debt immediately on schedule or perhaps anticipation thereof) is generally the immediate trigger of default, but obviously assets and net worth relate very significantly to the means of continuing to service that debt on schedule. Surely you wouldn't say that the risk of default is equal if one person or organization has the same projected net income as the other, but much higher net worth, would you?

That's my point, and by the way it wouldn't include consideration of only public assets, but also private assets, since sale of those assets is another source of revenue for debt service.

And as a note, some such metric could also capture a drain of wealth of a nation with a large, ongoing current account deficit driven by importing consumables (I'm rusty on the current account, capital account, etc. stuff, but the basic idea is essentially one nation sending an enduring asset [cash, land, etc.] to another in exchange for a consumable with is consumed, resulting in an asset on the other side and nothing left here)

Natural things are not capital assets classically, only the improvements.

But lots of improvements have been made, like the highways, roads, streets, and parking spaces. And the school buildings. And the ability of citizens to read and write and do arithmetic.

But let's simply sell the Interstate and US highways to private firms who will be allowed to charge whatever will maximize profits for their investment. Surely they will pay trillions for that revenue source given good credit terms, and they will also remove the cost of maintenance and improvements from the Federal government. States would logically sell all the local highways, streets, and parking spaces as well. (Chicago has sold all city parking to a private for-profit.)

The US government provided a square mile of free land and paid thousands per mile to build the rail lines that cross the US, and then charge property taxes and income taxes to the railroads. So, making the roads private would be no different than the railroads.

Until post WWI, the only high speed travel was on private carriage, the railroads, so it was the massive government enterprise that provided the road alternative, but it took Eisenhower to push for a highway system that would seriously compete with rail. Only a socialist would consider the government competing with private firms and driving them out of business, as happened the 70s, to be a good thing.

I'm sure many other services are provided for free by government in competition to the private sector that can be sold off to repay the debt that was run up to pay for building the assets.

Republicans have been in favor of cyclical fiscal policy for many years. Countercyclical fiscal policy is the ONLY way to reduce debt. Cyclical policy exacerbates it. The last president who tried countercyclical fiscal policy, Bill Clinton, ended up raising tax rates during an expansion and collecting more revenue than expenditures while the economy was booming.

Bush returned us to cyclical policy and enacted unaffordable tax cuts. Immediately we returned to debt. Instead of targeting spending during the recession at job creation, Bush did very little and let the Fed try to attack the problem with low interest rates and the creation of a housing bubble. In the weak job expansion, revenue suffered because too many were still unemployed. The unemployed draw government benefits and contribute less revenue. Only when unemployment was down around 4% did we have surplus.

During this time of high unemployment, Republicans want to cut spending and let unemployment fester. This will allow the unemployed to be a drag on our economy (they consume less) the unemployed will collect more benefits (make the deficit worse) and pay less in revenue (make the deficit worse).

Balanced budgets start with everyone having a job and contributing to the GDP. If unemployment is not fixed, the deficits and debt will not be fixed.

As to the tally of total debt, both current events and Reinhart & Rogoff show the importance of considering "off the books" implicit and hidden debts, made for various financial and political reasons, that suddenly become "on the books" -- sometimes on a massive scale -- when the day of problems arrives, making everything suddenly that much worse.

Greece it turns out was cooking its debt books with currency swaps and had points-of-GDP worth of implicit guarantees, not counted in its debt, for various projects and practices from the Olympics on. Ooops, that's all visibly due now. All those Dubai construction loans it turns out had implicit guarantees. Iceland seems to have been on the hook for a whole lot more in bank deposit guarantees than it ever thought when times were good.

Here in the US a financial crisis hits and suddenly the govt is $70 billion into
General Motors/the UAW (who knew?), Freddie and Fannie are suddenly "on the books" for potentially massive numbers, the Fed's balance sheet is massively expanded with investments it could take losses on if things turn for the worse instead of better, etc.

Imagine that California's politicians and voters keep it on its current fiscal course and that in the next crisis the state government goes bankrupt the way Orange County did in 1994. How much of the state's debt will wind up as the Treasury's? At a time when the federal debt is trillions higher than today's to start with, and the govt's balance sheet is again rocketing out in all directions to cover the crisis of the moment.

The measure of debt that matters isn't the 'official tally' of good times, when any plausible amount is affordable. It's the total actual amount that will have to be dealt with when bad times arrive, when the resources to do so may well be lacking.

Another important issue is the gross debt vs. the debt held by the public. This confusing distinction exists because for some years the federal government has taken in more in Social Security payroll taxes than needed to pay immediate benefits. By law this surplus is invested in special Treasury securities that are part of the debt subject to the debt limit that Congress must raise from time to time.

At the end of 2009 the gross debt was $11.9 trillion, $4.3 trillion more than the debt held by the public. Although many people get excited about this figure, it is in fact economically meaningless.

It is not merely meaningless -- it is grossly misleading for any coherent purpose.

The Treasury securities held in government accounts really amount to nothing more than budget authority permitting the Treasury to in effect use general revenues to pay Social Security benefits once current Social Security tax revenues are insufficient to pay current benefits, something that will happen in the year 2015, according to Social Security's actuaries.

Right. An interesting fact one can get from the SSA web site's history section is that the Trust Fund as we know it was created by accident by the '83 law changes. There was never any intention by Congress or the Greenspan Commission or anyone at the time to create a "trust fund" that would hold T-bonds to "fund" future benefits.

Another interesting thing is how everybody gets so livid in arguments over the SS Trust Fund and its bonds (and "default" on them, etc.) while ignoring the Medicare Trust Fund, which will be exhausted a whole lot sooner, and all the other smaller similar entities. Medicare isn't important to seniors?

There are two measures of debt that matter, in different ways.

#1 is the debt owed to the public for which bonds have been issued to the public. This debt incurs cash servicing cost that must be paid for by taxes, and is guaranteed by the Constitution so there is no getting out of it. At this writiting it is $8.06 trillion.

Ability to service this determines the credit rating of the US government, so it is important!

#2 is the "implicit debt" for promises to make future payments under such programs as Medicare, Social Security, federal and military pensions, and so on. At present value this is about $50 trillion over 75 years (closer to $100 trillion on an open-ended basis).

These are legally accrued future liabilities that under private-sector accounting rules would be on the balance sheet as debt -- but the govt keeps them off its balance sheet on the rationale that Congress can always change the law and thus them, so they are not really accrued liabilities. (Tell that to AARP and federal employees expecting their full promised pensions.)

These #2 amounts don't incur current cash interest expense and can be changed by law. But they do roll into #1, debt owed to the public, as time passes and the promised benefits become due. They are on course to do this in a big way starting in the 2020s and so have a big effect on the projected future credit rating of the US. So this is an important measure too.

The "gross debt", very often referred to as "the national debt", is a #3 measure that just adds a small, arbitrary portion of #2 -- the amount for which the govt has issued bonds to itself ($4.48 trillion) -- to #1, to get a purported debt total, the one seen on the National Debt Clock and such places.

But there is very little logic to it. The $4.48 trillion is indistinguishable from the rest of the $50 trillion (or $100 trillion) of "promise" liabilities, regardless of the bonds issued to mark it -- and entirely different from $8 trillion of debt owed to the public to which it is added.

That is, the intragovernmental bonds neither guarantee payment of anything (Congress can easily reduce SS benefits so the SS TF bonds never need be "paid off", and also never "default") nor do they represent the limit of any obligation (when the Medicare Trust Fund is exhausted, it is *very* unlikely that Medicare benefits will promptly be slashed by a corresponding amount because "the Medicare debt has been paid off".)

So this $12.5 trillion figure on the National Debt Clock is an awkward mix of fish and fowl. It is grossly misleading because it overstates the Constitutionally binding, interest-incurring debt of the US by 50% ... while it understates the total obligations of the US, including the financial promises made to seniors and govt employees, by a good 80%!

Either way it is highly misleading, too much or far too little. It should be ignored.

The accidental creation of the Social Security Trust Fund, and the follow-up accounting of the intragovernmental bonds in it as if they were bonds issued to the public, has really confused things as far as the Debt Clock is concerned.

The problem with dismissing default (or even partial default) by saying it would hurt lots of private investors who "are owed" the money is that it assumes it's morally legitimate for people to expect payment from Treasury securities. Principled libertarians, at least, would dispute that assumption. A Treasury bond represents a claim on future tax money-- that is, money paid by taxpayers who may not have been able to vote, or even been alive, when the bond was first issued! As such it should at the very least be regarded as no more sacrosanct than the "implicit" debt created by entitlement programs' promises. The future class of people who will expect payment on their Treasury securities is considerably less deserving of that money than the future class of people who they will try to force to pay-- and this is on purely procedural-justice grounds, without even considering the distributional consequences of transferring money from taxpayers to bondholders.

Posted by Nicholas Weininger on Mar 9th, 2010 at 10:47 pm.

CG&G is now on Forbes.com

Effective Feb. 28, 2014, Stan Collender's blog has a new home. Capital Gains and Games archives are available here, but for the latest posts, go to Forbes.com.